ETF liquidity misunderstood by financial advisors

Liquidity is the subject financial advisors understand the least about exchange-traded funds (ETFs), according to recent research from Cerulli Associates, a US-based financial services research firm. Although the research focused on US advisors, similar findings are reflected in the UK and across Europe.

He added: “ETF risks and the use of ETFs in portfolio construction were ranked as the top two topics that advisors understood the best. Liquidity and trading ranked the lowest, suggesting these two topics should remain top of mind for providers when developing educational programmes.”

Advisors understand that the more liquid an investment, the easier and more cost-effective it will be to trade. Similarly, they recognise that poor liquidity can translate into difficulties in entering and exiting positions, as well as higher trading costs.

However, many advisors think that the liquidity of an ETF can be determined by simply observing its trading volume. But a thinly traded ETF does not necessarily indicate low liquidity. In fact, ETFs offer two different sources of liquidity: traditional liquidity, as measured by secondary market trading volume, and liquidity provided by the creation/redemption process, which reflects the liquidity of the underlying securities within the ETF.

With a regular stock, average daily trading volume and market capitalisation reflect the natural liquidity of buyers and sellers coming together on an exchange. Although this partially accounts for the liquidity of ETFs, it is not the full picture. Thanks to the creation/redemption process, ETF liquidity does not solely depend on supply and demand on an exchange.

Unlike stocks, ETFs don’t have a fixed number of shares. Shares of an ETF can be issued and redeemed on a daily basis by Authorised Participants (APs) according to investor demand. This means that sellers don’t necessarily have to be matched with buyers. If there are more buyers than sellers, APs can create more shares to meet the higher demand. Conversely, APs can redeem shares for lower demand when there are more sellers than buyers.

What this all means is that the best measure of an ETF’s liquidity is not exchange volume, but the liquidity of the underlying securities, which in turn can be observed from average daily trading volumes and bid-ask spreads.

Cerulli suggests ETF sponsors focus on new advisors and continue to provide basic education to help address this knowledge gap. “Creating programmes to meet educational needs of advisors across the spectrum of adoption and sophistication is a difficult task, but it will be necessary for some time,” said Papazian.